Real Estate Capital Gains Taxes are Imposed on the Sale of Investment Property 

Capital gains tax is the money the IRS charges you based on the income that has resulted from the purchase, holding and then sale of a piece of property.  In most cases, the capital gains tax is due immediately following the sale of a property, with the amount you have to pay dependent on a number of different factors including: the type of real estate that has been sold, the amount the real estate was sold for, and the amount of money that you owed on the property at the time of sale.

Lets consider an example that will help explain this better.  Let us assume that you bought a property ten years ago with a price of $30,000, with a basis of $20,000.  Lets also say that at time of sale you got $115,000.  The amount of capital gains tax you would owe on this transaction would be the $115,000 minus the closing costs and real estate commissions ($15,000) minus the basis of $20,000, meaning that you will pay the capital gains tax based upon $80,000 of gains. Of couse, if you elect to do a 1031 tax exchange before close you may not have to pay any tax.

If you had a mortgage on the property, of say $90,000, you have to pay this amount off when you sell the property. However, the amount of capital gains tax you would need to pay would be off of the $80,000, because you had already had the use of the $90,000 mortgage while you owned the property.

If you invest in real estate, the amount of money you would have to pay in capital gains taxes can be quite substantial, which of course reduces your profit margin on each property and the amount of equity you could purchase in a subsequent property.  Section 1031 of the IRS Code is a scheme that helps reduce the amount of capital gains tax an investor may need to pay in any one year through availability of a 1031 exchange.

The premise behind Section 1031 is that if a property is not being used as the investor's primary residence, and if the property is either being held for business use or is land being held for investment use, then it is possible to get a deferment on the capital gains tax amount that may be incurred during the sale of such a property.  There are certain rules that must be adhered to under Section 1031.  For instance, the money from the sale of a qualifying property must be used to purchase another property; the bought and sold properties must both qualify under the definitions set out by Section 1031 and there are time restrictions that apply to the process.

To qualify under Section 1031, the selling of one property and the subsequent buying of another like-kind property must be done through the use of a Qualified Intermediary.  A Qualified Intermediary will facilitate the sale of the first property, and then hold the money involved in escrow until such time that a second or subsequent like-kind property has been found for purchase.  The Qualified Intermediary then arranges the purchase of the second property and all of the documentation that is needed to show proof that all of the conditions of Section 1031 have been adhered to.

Investors that use a 1031 exchange correctly with a reputable qualified intermediary may never have to pay real estate capital gains taxes.